As a business broker, I am continually asked to help people determine a fair market asking price for their business. As a matter of fact it is usually one of my first tasks in working with a prospective Seller. The only way I can determine if I am able to help a Seller sell their business is to determine if the asking price I think is reasonable for the business is in line with the Seller’s expectations.

Recently I was contacted by a couple who own a car wash. They had terminated their relationship with another business broker because he was not generating any prospective buyer interest and had not communicated with the Sellers on a regular basis. (The lack of communication from business brokers will be the topic of a future article.) As soon as I reviewed the Seller’s financial reports, I knew exactly why the previous broker was not able to attract a buyer and why he wasn’t motivated to call them so they could discuss it. The asking price was so high when compared to the net income that it did not and in almost every case could not make sense for a prospective buyer.

This very nice couple started this business less than one year prior to my meeting with them. They had invested a significant amount of money into the start up including equipment and fixture purchases, permits and leasehold improvements which is not uncommon for this type of business. They did a great job. The business looked great and provided an excellent service. The good news was that the revenue of the business was increasing every month. The bad news was that the revenue from the operation had not yet reached a level sufficient to cover the overhead expenses and provide a reasonable profit for the Seller. Some people may think this sounds like a great investment. Since the revenue is increasing every month, it is only a matter of time before a buyer could have a great profitable business. The key assumption in that theory is “could have a great profitable business”. In my opinion most existing businesses should be priced based on their historical ability to pay for themselves and provide a return on the buyer’s investment of time and energy.

Let’s look at this transaction more closely. The Buyers spent $400,000 to fully equip this business. The business was generating approximately $3,500 per month in net income. Due to circumstances beyond the Seller’s control, they needed to leave the area so they were expecting to sell the business for $450,000. This seems reasonable, right? They spent $400K to open the operation and get it going so $450K is not much more than their direct costs.

Let’s look deeper. If this were a commercial real estate investment, that rate of return, in some cases, would be considered reasonable. One major difference with this opportunity is that it is not a commercial real estate investment from the standpoint of effort required by the owner. In this business both the husband and wife were working the operation approximately 60 hours per week between the two of them. When you calculate the return on the investment for the buyer’s time and money. the net income, in my opinion, is not even close to sufficient to support the asking price of $450,000.

Another way to calculate this is to look at the business as if it were simply an absentee or even semi-absentee investment for an owner. How much would the company’s expenses increase if the hours the current owners worked were covered by an employee? For this business, in this area, my estimation is that it would cost the company approximately $2,500 per month to pay an employee to cover the hours the owner works. Keep in mind that this is not for an employee who would be making management decisions…. this is simply for an attendant. When you reduce the net income of the operation from $3,500 per month to $1,000 per month after covering the payroll, you can see why the return is not sufficient to warrant the asking price.

Now you may say this business would need to be sold to a buyer who will work the business just like the Seller. This is a possibility, but that requires an individual or partners who are willing to work for a combined 60 hours per week for $7.25 per hour, and receive a very minimal return on their investment of money, which in my experience can be very hard to find.

Initially the Sellers were having trouble understanding how their business could be worth less than it cost them to start it. Their point was that if someone wanted to start a new business like this they would have to spend the same amount of money. Not to mention all of the time to get it started and operational. And they are absolutely correct. The difference is that when people start a new business they invest their time and money with a plan and an expectation for what the business will produce. Once the business has demonstrated what it in fact is producing, it can be far less attractive to the fair market. Once I explained this situation to the Sellers they understood why the prior broker was not able to attract a buyer. I don’t know if the other broker didn’t understand the math or simply didn’t have the heart to explain the reality to the Sellers since they had invested so much time and money and he just hoped he could find the right person.

So what does the Seller do? Well I presented this open, very sincere couple with a few options. The first was to reduce their asking price to a price that the business, in its current status, would support. The second option was to continue to operate the business until revenue and profits from the business reached a level, for a sustained period, which would support the price they wanted. The third option I presented, in the event that they absolutely have to leave the area immediately, was to hire staff capable of operating the business in the Seller’s absence.

The last option I proposed, which had significant risks, was to offer the business for sale with seller carry back terms where the repayment schedule and potentially even the final purchase price were based on the future performance of the business. This type of arrangement, even though very risky and complicated, should insure the buyer received a return on their investment that is reasonable and provides the Seller with the potential that they will recoup, and in some cases exceed their initial investment without having to wait until the business can support the price they want. In any case I didn’t see any way the Sellers were going to get what they wanted from the sale of this business as quickly as they hoped. They decided to go with a combination of option number one and option number two. They decided to continue to operate the business until it would support a reduced asking price closer to the amount they had originally hoped for.

Please don’t misunderstand my point. I am frequently contacted by Sellers who were once buyers just like the Seller of this opportunity is seeking…individuals who had the money to purchase an opportunity like this one but weren’t coached on how the math worked or didn’t research the other opportunities that are available in the marketplace that could provide a better return on their investment. In this example these people started the business from scratch but more often than not the Sellers that contact me and are in a similar situation are there because they overpaid for an existing business opportunity in the first place.

There are other factors that influence the financial feasibility in this example such as the impact and ability to obtain adequate financing for a business with these circumstances. This is a topic I will save for a future blog article, but hopefully the point is delivered. For most people buying or selling a business is something they have not done before and in many cases is one of the most significant financial decisions they will make in their lifetime. There are lots of great business opportunities available in the market place. I strongly recommend that buyers and sellers do the research they need and work with a Broker capable of assisting them in getting the result they want.